While things have settled down and sales have even begun to rise in the battered semiconductor industry, there are still signs that the sector faces challenges this year and into next.

FBR Capital Markets, which has been watching the semiconductor supply chain like a hawk, issued a more cautionary note than it has been sending out recently following a visit to supply chain contacts in Asia. It found business conditions "are reasonably solid," and end demand appears to be improving, but chip inventory levels remain lean and there was no chip replenishment by OEMs in Q3.

That said, the company felt there are risks to Q4 production, without knowing how the holiday season will look just yet. The company cited three potential risks to Q4 production: the October 22 launch of Windows 7 and significant build-up of inventory leading to stockpiling, component shortages, particularly optical drives, hard drives, and DRAM, and a major upcoming holiday in China that might have pushed Q4 builds up into Q3.

Given all this, FBR wrote "our contacts said October builds will be the peak for PCs in 2009, whereas usually November is the peak build month. Given these checks, we are reducing exposure to the PC supply chain." It downgraded AMD (NYSE: AMD) and removed Marvell (NASDAQ: MRVL) from its Top Picks list.

Holding out hope, the company said Q4 sales would have to be watched for any surprises, either positive or negative. Improving economic conditions in the U.S. and Europe might spur sales on. It is projecting Q4 PC shipments to OEMs to grow about 15 percent sequentially from Q3.

Dean McCarron, president of Mercury Research, follows the supply chain and said Q3 was an "unexpectedly strong quarter. Going into Q3, we were expecting a weekly seasonal quarter and an increase in production but nothing too strong. We don't have final numbers from suppliers, but all evidence is that it was a much stronger quarter, coming in at the high side of seasonality," he told InternetNews.com.

That always leads to questions of why. Was it inventory demand, product builds, or something else?

"My suspicion is we had OEMs building systems on the supposition things were turning around and they didn't want to lose sales by not having systems built in Q4. We normally do to support demand in Q4 but it might have been a bit excessive because the growth rate was so strong," said McCarron.

Inventory fears remain

The only thing vendors seem to fear more than another collapse like last year is being stuck with inventory. The Dataquest Semiconductor Inventory (DASI) Index found that inventories are continuing to fall not just in chips but all parts.

Gartner, which owns Dataquest, said it expects the DASI Index will not stabilize until at least 2010, when Gartner forecasts the next year of growth for the semiconductor industry. It said inventories have only just now begun to fall from high to acceptable levels.

"While some industries are experiencing a fundamental demand-side recovery, other industries are benefiting from a reduction in inventory simply because of their continued conservative efforts in keeping the supply chain lean," said Gerald Van Hoy, senior research analyst at Gartner in a statement. "Concerns of possible shortages in inventory seem to be premature, but inventory should continue to be monitored, especially in large-scale markets, such as PCs and cellular phones."

Contrary to FBR's findings, Gartner maintains that concerns of possible shortages in inventory are premature, although shortages could potentially occur, they will most likely be few and far between, and, given the current end demand, short-lived.

Mercury's McCarron said he sees no sign of component shortages, nor has he seen it in a while, with one exception:

"DDR3 is in shorter supply, which has brought prices up. It's going mainstream, so that will do it. It happens every time we do a tech conversion in DRAM. This is a very natural progression. You see the prices rise, the product becomes mainstream and the price comes down again," he said.

Rough times for fabs

Not having so good a time will be the fabrication firms. Supply chain research firm iSuppli predicts 2010 will be a year where the foundry and fabrication business see serious consolidation, leaving just three major players.

The company projects that global pure-play foundry revenue will rise 21 percent from 2009 levels to $21.6 billion in 2010 while the semiconductor industry itself will rise only 13.8 percent. This is a major improvement over the 10.9 percent plunge in 2009.

But it will be the rising cost of competition that thins the herd. Moving to manufacturing processes like 45 nanometer, 32nm and 22nm, which giant Intel (NASDAQ: INTC) is doing, will become prohibitively expensive.

"The only way to be a leader and outperform the market is to stay at the cutting edge of semiconductor process development. Only companies with sufficient size can support these costs," said Len Jelinek, director and chief analyst for semiconductor manufacturing at iSuppli in a statement.

There has been some consolidation already. Globalfoundries, the fabrication spinoff from AMD, has acquired Chartered Semiconductor. There is a pending merger between Hua Hong NEC and Grace Semiconductor and United Microelectronics Corp. (UMC) is in a deal to acquire HeJian Technologies.

"When this consolidation process concludes, its likely that only three top-tier players will be left," iSuppli said.